Introduction to Options

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1 Introduction to Options By: Peter Findley and Sreesha Vaman Investment Analysis Group What Is An Option? One contract is the right to buy or sell 100 shares The price of the option depends on the price of the underlying, plus a risk premium It is an option, it is not a binding contract Call Option: Right to buy a share Put Option: Right to sell a share Options traded the same as stocks 1

2 What Makes Up An Option? The strike price is the price at which you can buy or sell shares Expiration date is the last day you can exercise an option Automatically executed on this day Underlying asset is the stock on which the option is written Price of the option is how much investor pays for the right to buy or sell (a.k.a. premium) Options can be either American or European American-style options can be executed on any day European-style options can be executed only on the expiration date What Is Contained In An Option? CALL Right to buy 100 shares Holder of option can buy shares at the strike price Thus, seller of option MUST sell shares at strike price if exercised Calls are in-the-money if the strike price is below the stock price Calls are out-of-the-money if the strike price is greater than the stock price Calls are at-the-money if the strike price is equal to the stock price PUT Right to sell 100 shares Holder of option can sell shares at strike price Thus, seller of option MUST buy shares at strike price if exercised Portfolio protection Puts are in-the-money if the strike price is greater than the stock price Puts are out-of-the-money if the strike price is less than the stock price Puts are at-the-money if the strike price is equal to the stock price 2

3 How Do I Find The Price Of An Option? Three components of the price of an option: Intrinsic Value: value of the option if exercised now Volatility: premium for protection against price fluctuations in the underlying stock Time Value: value of buying option instead of stock Money saved on initial outlay can earn interest What Are The Payoffs For A Call? Payoff on Option Payoff on Option C C LONG CALL Initially, buyer pays out price of Call (C) Value of long Call increases as value of Stock increases SHORT CALL Initially, writer receives price of Call (C) Value of short Call decreases as value of Stock increases 3

4 What Are The Payoffs For A Put? Payoff on Option Payoff on Option P P LONG PUT Initially, buyer pays out price of Put (P) Value of long Put decreases as value of Stock increases SHORT PUT Initially, writer receives price of Put (P) Value of short Put increases as value of Stock increases How Do I Use Options? Portfolio Insurance Speculation/Leverage Hedging (Which is actually a type of insurance!) Risk Control Targeted returns 4

5 What Are Some Basic Calls Strategies? Bullish Call Spread Bearish Call Spread Buy Call at 1 Write Call at 2 Lower Cost of Portfolio, but that limits upside Best if you think stock will rest between 1 and 2 at maturity Write Call at 1 Buy Call at 2 Take advantage of bearish sentiment by selling a call Hedge your bearish opinion by limiting downside YOU Draw the Diagram: Put Spreads Bullish Put Spread is the same as Bullish Call Spread, using Puts Bearish Put Spread is the same as Bearish Call Spread, using Puts

6 YOU Draw the Diagram: Put Spreads Buy Put at 1, Sell Put at 2. Use to maximize put portfolio during bull market Sell Put at 1, Buy Put at 2. Use to maximize put portfolio during bear market What Is A Straddle? 1 2 Straddle If you think that the underlying asset is volatile, but you don t know which direction, you can hedge yourself by buying both a Put and a Call at strike. You will make more money as the stock price moves away from. Strangles This is the same as a straddle, but with two different strike prices. This way, you can offset your costs by buying a cheaper call option or a cheaper put option, depending on how far apart you want the options to be. 6

7 How Else Can I Use A Straddle? Stock Strips If you think that the price of the underlying is going to increase, you can buy two calls and, for protection, buy one put. This takes the view that the stock price will go up, but protects you if the stock price goes down. Straps If you think that the price of the underlying is going to decrease, you can buy two puts and, for protection, buy one call. This takes the view that the stock price will go down, but protects you if the stock price goes up. What Is A Butterfly? For puts, the butterfly spread is : Long Put at 1 Short 2 Puts at 2 Long Put at 3 Stock A Butterfly Spread is the most widely used options combination. With calls : Long Call at 1 Short 2 Calls at 2 Long Call at 3 Investors make money on the premiums of the two calls sold, plus a potential payoff on the underlying stock price from the long positions. 7

8 YOU Decide: Why Are Options Useful? Risks of an option Unlimited downside risk when shorting (writing) options If they expire worthless, you lose 100% of your invested capital 8

9 Any Questions? 9

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